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Portfolio Fix: MLPs and Positive Returns

Advisors and clients appreciate the multiple layers of upside offered by MLPs and MLP-focused investments.

Savvy financial advisors know that these days of high market volatility and low interest rates demand strategic thinking to help clients reap fruitful investment returns. That’s why more and more FAs are relying on master limited partnerships to capture yield, reduce portfolio risk and hedge inflation.

There are 81 energy-related MLPs with a market capitalization totaling $350 billion. Since 2009, they are up close to 180% on a cumulative basis through March 2012. With their low correlation to the S&P 500 and broader market, MLPs are a four-star diversification tool.

“MLPs are getting more popular with advisors. There is still somewhat limited knowledge about them; but we’ve definitely seen interest grow in the last two years as investors have become a little wary of depending on price appreciation, and the market has had some gyrations,” says Mary Lyman, executive director of the National Association of Publicly Traded Partnerships, based in Arlington, Va., in an interview. “People are looking more for dividends and investments that generate income, and MLPs have fit the bill.”

With a current yield of 6%, plus forecasts of quarterly distribution (dividend) increases of 5% to 8%, and total return in the 10% to 15% range, MLPs are indeed appealing to many investors, financial experts say.

Advisors who use them — and some began investing in MLPs back in the 1980s — are enthusiastic about the impressive performance of this still-young, emerging asset class.

“We see MLPs as an alternative because they act differently from either fixed income or equities and should perform differently from the S&P 500,” says Phil Blancato, CEO and president of Ladenburg Thalmann Asset Management in New York, in an interview, who recently rebalanced $1 billion of managed portfolios to include about 2%-3% of MLPs.

A master limited partnership is indeed unlike any other type of investment product. “It’s not quite an equity. It’s not quite a bond. It’s a kind of equity-yield hybrid,” says Michael Bollinger, a managing director at Morgan Stanley Smith Barney private wealth management in Houston, in an interview. Bollinger uses MLPs with his ultra-high-net worth clientele whose $300 million in assets he and his team manage on a discretionary basis.

“MLPs have been the No. 1 performing asset class over 10 years,” says Bollinger, who started using MLPs 16 years ago. “Every client we’ve had in the strategy — since 2003 — has had a very good experience.” Nearly all of Bollinger’s clientele has a portion of their portfolios allocated to MLPs, he notes.

Most popular with advisors are the midstream MLPs — the “middle men” of the energy chain; the other two segments are upstream — exploration and production firms — and downstream companies. “The E&Ps have to go and find more energy; the midstream companies don’t have to find energy — they just have to transport it,” Bollinger says.

Seeking appreciation as well as income for his base of corporate-executive and high-net-worth family clients, Richard Happle, senior vice president of investments with Raymond James & Associates in Tampa, Fla., invests client assets in upstream MLPs, of which there are only a handful. He likes LINN Energy (LINE) because of the company’s “high organic growth rate. And whenever they make an acquisition,” he says, in an interview, “they have the best hedging strategy of any MLP. We’re expecting a 35% total return from LINN.” (Happle’s investment experience with MLPs dates to 1984.)

Looking for diversity in energy exposure, some advisors invest in both propane and coal MLPs. Although coal is off right now, according to John Thorsen, a senior vice president of investments at Raymond James in Orlando, he expects to see some changes. “What we look for in situations like this,” he says, in an interview, “is a high income flow that seems sustainable so that people are basically getting paid to wait for things to get better. Thorsen and his team manage assets of $400 million.

But clients needn’t be in the high-net-worth bracket for MLPs to be suitable. “MLPs are for any investor who might be interested in income at any point in time,” notes Linda McDonald, vice president of hard assets with Segal Rogerscasey in Dublin, Ireland, in an interview.

At Edward Jones, MLPs are proving to be a sought-after product for clients. “Our clients are buying a lot of MLPs that have high yield. [That’s] because when the market goes down, interest rates are low, and their fixed income vehicles aren’t returning what they had in the past, they look for higher yield,” says Andy Pusateri, a senior utility analyst, based in St. Louis, Mo., in an interview.

“And in view of the financial crisis, along with the low-interest-rate environment that we’re in, people are searching not only for yield but for what they feel are safe investments,” Pusateri explains.

Clients are also looking for quality. “With fixed income, to get the high yield you do with MLPs, you need to dip down in quality and invest in junk bonds,” says Ashley Lannquist, investment research analyst with Segal Rogerscasey in Darien, Conn., in an interview.

On top of yield enhancement, MLPs can lessen portfolio volatility. “Some clients are still concerned about what happened in 2008 and don’t want to repeat that experience where everything dropped dramatically,” notes Thorsen, who has worked with MLP investments for 18 years. “They feel that when we do see another market correction, they want that income to give them some perceived cushion to the volatility.”

In May, concerned about volatility in oil pricing, Blancato replaced his natural-resources allocation — a fund representing about 5% in managed portfolios — with a direct investment in MLPs.

“That has proven to be very beneficial because with natural resources down as much as 14% year to date, the MLPs in that same sector are down roughly only 2.3% for the same period,” he says. “We thought: How can we remove the volatility? The MLPs are still in the energy sector but are [performing] as a dividend play rather than a total return play — and that’s very important.”

About 3% of portfolios owned by Blancato’s clients — which have an average account size $225,000 — are invested in MLPs; some higher-net-worth clients have a larger allocation.

Toll-Road Model

Blancato generally sticks to the midstream space, and he uses a simple analogy to explain to clients how pipeline companies get paid on the volumes they pass through their pipelines, which makes them less sensitive to commodity prices.

“An MLP,” he says, “is like the [N.J.] Garden State Parkway. Whether the price of gasoline in a car is $10 or $2 a gallon, the Garden State Parkway is indifferent. It will charge that car a toll every time it drives up or down. An MLP is basically a highway for natural gas and oil. We need to get it out of the ground and move it. So the MLP acts as a toll road for a commodity.” That explanation, he says, “works well with folks.”

MLPs are especially suitable for retirement portfolios. “They’re ideal because the dilemma today for income investors is that you can’t find attractive income without taking risks in either buying low-quality bonds or long-maturity bonds,” Happle says. “The advantage of MLPs, particularly for long-term investors, is that they are operating businesses that have a history of showing 6% distribution growth.”

In keeping with MLPs as retirement investments, many advisors are using them for inflation protection, since distribution increases have, over the years, outpaced the rate of inflation. “They are very much an inflation play,” Blancato says. “MLP contracts — and hence, revenues — are often tied to inflation indicators such as the Producers Price Index.”

As Pusateri points out in a recent MLP report: “A distribution that is increasing consistently every year can help offset the impact of inflation over time.”

For Thorsen, the type and extent of MLP investments depends chiefly on client risk tolerance. “For some of our more aggressive clients, an MLP that pays a solid income might be a more conservative portion of their portfolios. For some of the more conservative clients, it might be a more aggressive portion,” he shares.

This means “the people that need income are focusing on the higher income-paying vehicles and probably have a little higher percentage of their portfolios in MLPs, because right now they pay very nice income,” the advisor notes. “The folks that need no income and are more aggressive tend to have fewer MLPs. But the vast majority of my clients have some MLPs in their portfolios.”

One of Thorsen’s clients has done so well that he snagged a 30% compounded return investing in MLPs. “It was unusually good — not typical by any means,” the FA stresses. But his client, who had been focusing on MLPs since 2009, was “very concentrated in them and a real believer. He went against my suggestion to have more diversification. But so far, it’s worked great for him.”

Digging Deep

Bollinger employs a comprehensive screening process with a diversification theme. “First we look at geographies the company is playing in, because I want a diversification of that. I wouldn’t want anyone that’s concentrated, say, only on the Gulf Coast, because if a hurricane came and shut down transportation for a period, that would be a problem.”

The advisor also looks “at diversification across the value chain — crude oil MLPs, natural gas liquids, refined products. You start to build a value map for each company: What products do they play in? What geographies? What types of midstream? Are they gathering and processing systems or transportation systems moving the [energy] to a distribution point? If [the latter], do they have big intrastate systems transporting it, or do they have interstate pipes that connect across multiple states?”

The risk profiles are different for each company, the advisor adds. “When you think about Enterprise Products Partners (EPD) and Kinder Morgan Energy Partners (KMP), the two biggest in the space, you can check almost all the boxes as far as diversification goes,” says Bollinger.

He also hones in on the company itself to see how it’s capitalized. “One of the most important things we look at is the debt-to-capitalization ratio. The other key statistic is the distribution coverage ratio,” the advisor says. “We like to see that at about ‘one’ because if it’s not, they’re borrowing money to pay the limited partners.”

Bollinger then meets with the MLP’s management to understand product mix and to determine whether commodity exposure or counterparty risk exist. Of course, he studies balance sheets, then drills down to how the companies plan to grow distributions over time.

“It’s important to know how management is thinking about that,” he says. “We spend a lot of time with these companies and always try to avoid blow-up risk. We try to run [MLP allocations] as conservatively as possible, which is why we stay in the midstream and not the upstream space.”

McDonald says that diversifying among MLPs themselves is a good idea. “Don’t have so much single risk in only one MLP. Have a basket of them. One reason we advocate that investors acquire a diversified portfolio of MLPs is because of management risk — how the general partners are managing the assets and running the MLP.”

The addition of an MLP allocation can help reduce a portfolio’s overall risk. Blancato uses MLP dividends to balance returns. “Capturing a dividend will smooth out the downside of the return stream . [That means] it will have achieved less on the upside,” he explains. “But it’s one way to reduce risk. The other way is to have an asset allocation that is not overly susceptible to economic and geopolitical events.”

Speaking of the latter, Thorsen shares that a few of his clients are investing in MLPs with the notion that “they’re getting paid income while waiting to see if Iran gets bombed or if there’s some other political unrest.”

MLP Options

There are a variety of ways to invest in MLPs apart from owning the individual units. These include closed-end fund MLPs, mutual fund MLPs, exchange-traded fund (or ETF) MLPs and exchange-traded note (or ETN) MLPs. All of them allow investors to get a piece of the pie using a bundled approach — either passively or actively managed — and avoid the tax complexities of investing in individual partnerships.

“There is a proliferation of these products, because the tax filings are a significant enough hurdle for investors not to want to deal with them,” says Kenny Feng, CEO and president of Dallas-based Alerian, in an interview.

“Collectively, it’s a pretty meaningful pool of capital that has come into the sector for an asset class that is [only] about $350 billion of market capitalization,” Feng says. ETNs and ETFs total about $9 billion, and open-end funds come to another $3 billion. Combined with closed-end MLPs, about $20 billion in total has been invested using this approach.

The first closed-end MLP was launched in 2004; in 2007 an ETN was introduced. The first open-end mutual fund and ETF came on the market in 2010, according to Feng.

“In the last couple of years, in particular, there have been a lot of new funds, especially open-end MLPs,” says Lyman. “That part of the sector has grown a lot, as well.”

One of the biggest MLP funds is an ETN, the JP Morgan Alerian Index ETN (AMJ), according to Alex Ashby, research analyst with Global X Funds in New York, in an interview. ETNs “expose you to the credit risk of the issuer, whereas with an ETF, you are fully invested in the underlying securities and don’t have the same sort of credit risk. An ETF replicates the index more accurately,” he says.

In April of this year, Global X Funds introduced the Global X MLP ETF (MLPA), which invests mainly in midstream transportation, pipeline, storage and processing MLPs, as well as exploration and production companies. Composed of 30 MLPs, the fund seeks correlation to the price and yield performance of the Solactive MLP Composite Index.

“You get exposed to the energy industry but not necessarily to the underlying commodity prices,” Ashby notes.

At Edward Jones, the Alerian MLP Index ETF is “very popular with most of our clients,” Pusateri says. “The reasons are that you get instant diversification within the industry and a 1099 instead of a K-1”

In his recent report on the MLP industry, Pusateri writes that the Alerian “has outperformed the S&P Energy Index” since its 1996 inception “largely due to higher income.”

Blancato uses both ETFs and ETNs with his broad-based clientele. In a small mutual fund, the Ladenburg Thalmann Strategies Fund (LTAFX), that he manages, 25% is allocated to MLP stocks. “The fund has had excellent performance over the past 20 months in large part because of the MLPs,” Blancato notes.

Happle derives some MLP exposure by way of a unit investment trust from First Trust. “You can get a basket of 15 or 20 MLPs. That’s a good way for a smaller investor to get easy diversification,” he says. “The UIT has diversification. But it’s not over-diversified with too many names — and it gets you past the tax issues, so you don’t have to worry about that.”

The global financial crisis prompted greater interest in MLPs. “After the Alerian [MLP] Index hit its bottom,” Feng says, “people realized that the MLPs were still generating stable cash flow and that you could get an investment-grade company that was continuing to pay distributions and was even growing its distributions as a double-digit yield. There was a V-shaped recovery in the asset class, which has not been the case for the broader economy or the S&P 500.”

Blancato began tracking MLPs during the meltdown and says he was “surprised and happy” with their performance. “We were looking for asset classes that were less impacted by the crisis and would pass a high-quality dividend. We looked at the MLP distributions. For the most part, they were significantly less affected than the broader market; and when they rebounded, they not only recouped all their losses but in 2008 were up 76%.”

The following year, Blancato reduced his allocation to managed futures and replaced it with MLPs.

Down the road, advisors look for the MLP sector to remain an important, useful portfolio component. Those perpetual high-income yields are a big draw.

“Clients will continue to desire higher-income vehicles, and that will attract people to MLPs. We’re looking for better-than-average returns, especially compared to other alternative products,” Thorsen says.

The increase in energy production coupled with a shortage of pipeline infrastructure point to ongoing demand for the services of midstream MLPs.

“There is demand for $200 billion to $300 billion of new pipelines. We think that MLPs should, on a regular basis, outperform the S&P 500. MLPs are very, very valued,” says Blancato. “And by 2030, we could be an energy exporter. Natural gas is the golden lever that fixes the [problems of] the U.S.”

Though most MLPs have little direct exposure to commodity prices, advisors who invest in the partnerships keep careful watch on price movement.

“Next year we could see oil dip to about $80 a barrel and over the next year or so, production increase,” Happle says. “It would make sense to get some midstream and downstream MLP exposure because those two do the best if oil prices decline.”

Apart from the satisfying returns, advisors are also pleased that investing in energy MLPs appeal to clients’ patriotic pride. For instance, when Blancato highlights the sector during portfolio reviews, he finds that “clients get warm and fuzzy knowing there’s something we can do as a country that can improve it. It makes them feel positive on the United States,” he says.